Kotak Midcap Fund to become a small cap fund

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As part of the reclassification of schemes mandated by Securities Exchange Board of India (SEBI), Kotak AMC (asset management company) has reclassified Kotak Midcap Scheme as Kotak Small Cap Fund. The benchmark of the scheme has been changed from Nifty Midcap 100 to Nifty Small Cap 50.

What has changed?

The current mandate of Kotak Midcap says “The Scheme will predominantly invest in midcap stocks. The stocks falling within the market capitalization range in the underlying benchmark viz Nifty Midcap 100 would be considered as midcap stocks.”

The revised mandate says, “The investment objective of the scheme is to generate capital appreciation from a diversified portfolio of equity and equity-related securities by investing predominantly in small cap companies.” Small cap companies are defined by SEBI, which are stocks whose market cap is below the top 250 listed companies by market capitalisation.

As mentioned above, the scheme’s benchmark will also change from Nifty Midcap 100 to Nifty Small Cap 50

What happens to the existing portfolio?

According to Morningstar, 69% of the fund’s portfolio is invested in large and mid-caps. The new rules require that at least a 65% of the fund’s portfolio be invested in small caps, defined as those companies whose market cap is below the top 250 listed companies. In other words, the fund would have to cut down its 69% large and mid-cap investment to below 35%.

Kotak Midcap scheme has an AUM of Rs 819 crore.

What about ratings?

Mutual Fund ratings in India are done by information companies like Value Research, Morningstar and CRISIL. There is no explicit statement on how mandate changes will affect ratings by Value Research and CRISIL. This is an important question because ratings are based on data like past performance which become irrelevant when one scheme morphs into a totally different one.

In a statement released on 4th April 2018, Morningstar said, “In case there is a dramatic change in mandate, in which case the historical returns of the fund become irrelevant. In such cases we have the option to suspend the rating on the fund if deemed appropriate and only consider it once it completes 3 years under the new mandate. For example, a sector fund now categorized as a large-cap fund.”

You can find the full statement here. It is unclear whether the rating agencies consider a shift from a midcap to a small cap fund to be a ‘dramatic change in mandate’. The current Morningstar rating at just two stars is not very high for this scheme. Value Research assigns it a rating of three stars.

The options before you

The changes will go into effect on 25th May 2018. If you do not agree with them, you can exit the scheme without paying exit load by 24th May 2018. However, you may have to pay capital gains tax. This will be 15% of your gains in the fund if it’s held for less than one year (short-term capital gains) and 10% of your gains if it is held for longer (long-term capital gains). In case of long-term capital gains, the gains made before 31st January 2018 will be exempted and you will get a tax exemption on gains made up to Rs 1 lakh.